Property Right Approach and Emissions Trading Schemes

Abstract

The economist R. Coase observed that environmental problems can be resolved through bargaining between the affected parties as long as property rights, or rights to own or use the environment, were established. He also recognized that in many cases, transaction costs make bargaining difficult. This chapter first explains the Coase Theorem, property rights, and issues of transaction costs. We then extend the discussion by examining emissions trading, a policy instrument inspired by Coase’s insight. We provide an economic explanation that demonstrates how the trading of pollution permits works as an efficient market-based instrument for reducing emissions.

1 Property Rights to the Environment

In Chaps. 1 and 2, we argued that environmental problems will not be resolved without government intervention and then discussed the advantages and disadvantages of the interventions such as subsidies and environmental taxes. In contrast to these arguments, Ronald Coase (1910–2013), a British-born American economist who earned the 1991 Nobel Prize in Economics, contends that environmental problems can be resolved without government intervention, as long as property rights (i.e., rights to own and use a good or resource) to use the environment are established (Coase 1960). If this theory, usually referred to as the Coase Theorem, holds true, then the role of government in managing environmental issues becomes a lot easier. Assigning property rights to all natural resources will be the sensible environmental policy.

In what follows, we will explain the Coase Theorem. In particular, we consider a situation where a factory belonging to a profit-maximizing firm produces air pollutants as by-products that are health hazards to local residents. We will then compare the outcomes across three different assignments of property rights: (1) no one holds property rights (i.e., the absence of property rights), (2) the rights are held by the residents in the polluted region, and (3) the rights are held by the polluting firm.

1.1 The Model Setup

Think about typical pollution problems, like the health hazards to local residents caused by factories’ pollutants. For example, Yokkaichi Asthma, one of the four major pollution-caused diseases in Japan, occurred under very similar circumstances. In the city of Yokkaichi in Mie Prefecture, the incidence of asthma began increasing in the early 1960s. The main cause of the incidence was sulfur oxides and other pollutants emitted from petroleum complexes and other factories in the area (ERCA 1997).

As in the example, we consider a firm that produces air pollutants as by-products of production. For this firm, we assume that the more output is produced, the more profit is made, but at the same time, the amount of pollutants also increases. These relationships are succinctly expressed in Fig. 3.1; it illustrates how the private benefit (which is the firm's profits/surplus) and the cost of pollution damage vary across different levels of output by using the marginal private benefit (MPB) curve and the marginal external cost (MEC) curve, respectively.

Fig. 3.1

Marginal external cost curve and marginal private benefit curve

1.2 Marginal Private Benefit

The marginal private benefit (MPB) is the additional profit the firm makes from producing one more unit of output; in other words, it is additional to the private benefit when an additional unit is produced. This means that the private benefit is the sum of private marginal benefits of the number of units produced. The marginal private benefit curve exhibits the relationship between the marginal private benefit and the level of output; the private benefit is therefore equal to the area under the marginal private benefit curve. For example, when the level of output is F (Q), the private benefit is represented as area OFEA (OQA).

The marginal private benefit curve is negatively sloped, reflecting that as production increases, the cost of production of one additional unit of output increases. For example, if an employee must work overtime or on holidays to increase production, the firm has to pay a higher rate of compensation to the employee. The cost of producing an additional unit becomes more expensive for the firm as the wage per unit of time increases.

The marginal private benefit curve tells us how much the firm produces in the absence of government intervention; the firm chooses to produce a quantity of Q, as it continues to operate until the incremental benefit from producing one more unit becomes zero. Below we will see, however, that Q is not a socially desirable level.

1.3 Marginal External Cost (MEC)

To identify the socially desirable level of output, it is not enough to look at the marginal private benefit curve alone; we also need to consider the external costs to society of pollutants caused by the firm's production. For example, in Yokkaichi, air pollutants emitted from petroleum complexes and other factories caused many people to suffer from chronic bronchitis, bronchial asthma, emphysema, and other health problems. Those who were severely affected by the pollution must have sacrificed their work and leisure time to attend to their health or be admitted to hospitals. Even for those who did not suffer much, the polluted air must have been unpleasant; in industrial cities in Japan in the 1960s, visibility was so poor due to sulfur oxides, soot and dust that one could not drive a car without turning on the headlights even during the day (ERCA 1997). Just like these examples, we assume that emissions caused by the firm's production are harmful to local residents (even if emissions do not cause health problems). We therefore consider the corresponding pollution damage as the external cost of the firm's production to society. We assume for simplicity that the amount of air pollutants is proportional to the level of output.

For analysis, all of the damage caused by the pollutants is translated into monetary terms. Then, the marginal external cost (MEC) is the additional external cost (i.e., the additional damage expressed in monetary terms) to society of the firm's producing one more unit of output. The marginal external cost curve in Fig. 3.1 exhibits how the marginal external cost is associated with the level of output. The marginal external cost curve is positively sloped, reflecting that the health hazards caused by one additional unit of emissions are often greater than those by the first unit of emissions.

The total external cost (i.e., the total amount of damage expressed in monetary terms) corresponds to the lower area of the marginal external cost curve. As you can see in the figure, the lower area increases as the output increases. For example, if the level of output is F, the magnitude of the damage is represented by area OFD; likewise, if the level of output is Q, the magnitude of the damage is represented by area OQB. This pattern reflects that an increase in production results in an increase in the amount of emissions and thus the damage.

1.4 Absence of Property Rights

We now consider the Coase Theorem by examining the outcome under three different assignments of property rights. We first examine the case when the property rights are not established, in other words, when the property rights are assigned to nobody. In this case, the level of output is determined by market equilibrium; accordingly, the firm chooses to produce a quantity of Q where the marginal private benefit is zero (i.e., the private benefit is the greatest), and the corresponding producer's surplus is represented by area OQA. It should be noted that this level of output results in the pollution damage where the external cost of production to society is represented by area OQB. If we define the social benefit to be the private benefit minus the external cost, it can be represented as “area OQA – area OQB” in the figure.

The market equilibrium in the absence of property rights is not desirable from society's vantage point. Suppose that the output is reduced from Q by a little. Then, the polluting firm's benefit is slightly reduced, but more than that, the pollution damage is reduced. In the aggregate, the social surplus has increased. Indeed, the social surplus can be made larger as long as the marginal external cost is larger in magnitude than the marginal private benefit. Put differently, the social surplus is greatest at the intersection of the marginal private cost curve and the marginal external cost curve, as represented by area OCA.

Some people may wonder how pollution damage is transformed into monetary terms. One way of doing so is based on how much monetary compensation people are willing to accept for the damage they experience. For some damage, however, people may be unwilling to accept monetary compensation, no matter how much it is. For example, one may contend that the damage of ozone depletion caused by chlorofluorocarbons should never have happened. In such a case, the magnitude of the damage is considered as infinite so that the marginal external cost curve is a vertical line through O. The two curves will then intersect at the zero production level, meaning that the socially desirable output becomes zero.

Box 3.1 Divers and the Fishery

Many divers come to the Okinawa Islands to enjoy the beautiful coral, but who owns the ocean they dive in? In fact, conflicts between local fishermen and diving companies over the use of the ocean can be problematic. Fishermen, who own fishing rights, claim that the divers who come to the islands violate their rights and demand nuisance fees from diving companies who bring in divers. Many companies have complied but some haven’t. Who is right?

The right to fish is the right to make a living by fishing in a given body of water. If catches are reduced due to the presence of divers, it means that the divers violate the rights of fishermen and they need to compensate the damages. In this case, negotiations determine the number of divers, the catch, and the amount of compensation—the world that Ronald Coase envisioned will come true. However, if there is no evidence that divers caused a decrease in the catch, one can argue that diving companies have a reason for not paying the compensation. The problem lies partially with the fact that the right to fish is established while the right to dive is not.

1.5 Maximizing Social Benefit Through Property Rights Assignments and Bargaining

We have discussed a case where property rights to the environment (specifically property rights to the atmosphere in our discussion) are not explicitly defined. In such a case, pollution and environmental problems arise. Ronald Coase contends that the lack of clarity as to who owns the right to the environment is the cause of the problems. He also argues that once property rights are established, bargaining between polluters and victims will take place, leading to a socially desirable outcome.

1.6 Property Rights Assigned to the Residents

Consider the case where property rights are assigned to the residents (or the victims of pollution). It means, in our example, that the residents have the right to breathe clean air. The polluting firm infringes on that right and emits smoke, causing damage to the residents; the firm therefore must compensate for the damage. The residents then bargain with the firm to demand the compensation.

Suppose that the firm initially produced a quantity of Q, as in Fig. 3.1. As the residents own property rights, the firm must compensate them for the damage represented as area OQB. The compensation would obviously reduce the firm's profit and might even cause the firm to fall into the red. To reduce the burden of compensation, the firm therefore would consider reducing the quantity of output. Now, suppose that the output is reduced to a quantity of F. Then the profit will decrease by area FQE, but the amount of compensation will be reduced by area FQBD; the decrease in compensation is greater in magnitude than the profit lost. The burden on the firm will therefore be reduced if the level of output is reduced to F.

For the firm, it is in its best interest to further reduce its production volume; as long as the marginal external costs are greater than the marginal private benefits, the firm will be able to reduce the compensation burden. However, if the marginal external cost is less than the private marginal benefit (on the left side of Q* in the figure), the portion of the decline in profits will be larger than the reduced portion of the compensation. Therefore, there will be no reason for the firm to reduce its production to the level below Q*.

For residents, there is no reason to demand that the firm reduce production further than Q*. Even though the firm produces pollution, it provides equivalent monetary compensation as represented by area OQ*C. The level of residents' satisfaction with their lives is the same as it would be if there were no pollution damage at all (in other words, the external costs borne by the residents are zero) and the producer surplus of the firm is area OCA. In this case, the social surplus is maximized, and the socially desirable output is achieved.

1.7 Property Rights Assigned to the Polluter

Now let us consider the case where property rights are assigned to the polluting firm. In this case, the firm has been endorsed to pollute the atmosphere, so, moral issues aside, there would be no legal problem in producing emissions. Suppose, as before, that the firm initially produced Q in Fig. 3.1. Would the residents, who have no rights, be satisfied with the production Q? If the residents act rationally, they will begin to bargain with the firm to decrease its production. For example, if production is reduced to F, the firm's profits will be reduced by area FQE, but then the damage to the residents will be reduced by as much as area FQBD. If the residents compensate the firm's profits by the size of area FQE, the firm should have no objection to reducing its production to F. The residents pay the firm only for area FQE and obtain the utility of area FQBD (i.e., the damage is reduced), so they gain by the amount represented by area QBDE. In other words, the rational course of action for the residents would be to have the firm reduce its production and to compensate the firm for the lost profits.

Bargaining to reduce production and compensate for lost profits lasts until production becomes Q*. If production is reduced below a quantity of Q*, the reduction in damage is less than the benefit to be compensated. Hence, there is no incentive on the part of the residents to compensate the firm's profits. Here we see that the social surplus is maximized through bargaining even when the firm owns property rights. If the government is concerned with increasing social welfare, it does not need to worry about who to assign property rights to, as bargaining among the affected parties will solve that issue. It should be noted, however, that depending on who owns property rights, the incomes of the polluter and victims will vary (see Box 3.2).

Box 3.2 Determining Ownership and the Problems of Distribution

The Coase Theorem states that in solving environmental problems, it is important to establish the right to use the environment, and it does not matter who owns the right in the first place. Regardless of who has the right of use, negotiation solves the problem and maximizes the social benefits.

However, the distribution—who benefits and how much—depends largely on the determination of ownership rights. For example, what about giving rights to the polluter as in the example in this chapter? It is not socially acceptable for victims to compensate polluters. This is particularly so given that residents of the areas that suffer from factory pollutions are not necessarily wealthy. Pollution problems caused by nuisance facilities such as hazardous chemical plants and waste-related facilities in low-income neighborhoods are often reported in the United States as well. These issues have been discussed in terms of environmental justice in recent years. From the perspective of environmental justice, it would be appropriate to give the victim the right to use the environment in the case of pollution problems like the one discussed in this chapter.

2 Limitations of the Coase Theorem

2.1 Transaction Costs

So far, we have seen that under the Coase Theorem, once property rights are assigned, regardless of who owns the rights, a socially desirable outcome may be achieved through bargaining. Put differently, environmental problems persist because the affected parties cannot bargain with each other in the absence of property rights.

In practice, will the social surplus be maximized through bargaining as long as property rights are established? To answer this question, we need to consider transaction costs, that is, costs associated with bargaining. For example, victims of smoke emissions from a plant must spend a reasonable amount of time to bargain with the plant (e.g., take time off from work, cut back on household chores, and/or cut back on leisure time) to get to the negotiating table. Transaction costs also include fees and expenses to hire an attorney for the bargaining. All these transaction costs are not included in the marginal external costs because the external costs are the damage caused by smoke emissions, not the costs of bargaining.

Let us consider transaction costs in the case where property rights are assigned to the residents in the polluted region. If the residents' incremental utility from bargaining is smaller than the lost income due to taking time off from work, then bargaining is not likely to occur because there is no rationale for them to bargain. As such, pollution abatement may not occur, and the residents would have to put up with polluted air. Accordingly, the social surplus is not maximized even if the residents own property rights. Transaction costs can be significant for the victims of pollution damage, as exemplified by Yokkaichi asthma. The first spate of Yokkaichi asthma cases occurred in 1961, and the victims sued the polluters in 1967. In 1972, the district court ruled on the case. These intervening years lasted about ten years, and at the peak, the number of certified patients was 1,140 after 1970 (ERCA 1997).

Transaction costs of environmental problems tend to be expensive partly because the environment has a public good nature (See Box 1.1 in Chap. 1 for further discussion on this point), often making it difficult to estimate damage caused by them. While it may be possible to quantify health damages and missed income caused by air pollution, how can we accurately measure discomfort caused by pollution? In the absence of accurate estimates, individuals may have incentives to overreport the damage in order to receive more compensation than they are supposed to. Furthermore, theoretical studies suggest that this kind of self-interested behavior, if revealed to others, might lead to more people overreporting the damage they received, which may in turn result in breaking the bargaining. These consequences are attributed to the fact that the damage of environmental pollution is a negative public good and therefore shared by a number of individuals.

2.2 Problems with Identifying the Polluter for Bargaining

Another problem of the Coase Theorem lies in identifying the polluter for bargaining. For example, in an industrial area with many plants, it is difficult to identify which firm has caused environmental damages to which areas/residents and to what extent. This is especially the case with vehicle emissions, as exemplified by the Amagasaki air pollution lawsuit that resulted in settlement in 2000. In the lawsuit, the causes of pollution were identified as emissions not only from plants but also from vehicles, which means that the drivers were also considered as polluters.

In the case of drivers, identifying the sources of the damage and affected parties (i.e., whose cars have caused how much damage in which area) is even more difficult than in the case of plants. In addition, the impact of vehicle emissions on human health and the environment varies depending on so many conditions such as the level of congestion and time of a day the vehicle was used. Moreover, while it might be possible to identify the time and place of using a vehicle for business and commuting purposes, it is quite difficult to do so for private usages. If the relationship between polluters and victims is complicated as the case described above, victims will not know with whom they should bargain, and hence, the Coase Theorem does not hold.

This argument also applies to the issue of climate change. It is the current or previous generation who has been relying on fossil fuels such as oil and coal that have caused climate change. Nevertheless, the victims of climate change are the future generations and many of them are not even born. The victims are not on the negotiating table yet. One could argue that some of the current generation represent their interest in lieu of future generations. However, this does not mean that bargaining between the current and future generations is taking place in the way explicated by the Coase Theorem. Given that the majority of the current generation does not choose public transportation over private vehicles to mitigate the damage of climate change, it is clear that the social surplus is not maximized.

Note that the examples presented here is a classic example of air pollution. However, the idea of Coase's theorem can be established in many places for problems with externalities. For example, the construction of a high-rise building can deprive the surrounding residents of their right to light and generate negative externalities. The same argument holds true in such cases. If the residents of the affected neighborhood have the right to light, they can demand that the height of the building to be constructed be reduced. It can be expected that the outcome of the negotiations will settle on a socially desirable height.

Box 3.3 Tokyo Station and Air Rights

Coase’s theorem is also applied in urban development in Japan. A case in point is the major renovation and earthquake retrofit on Tokyo Station. World War II air raids damaged and destroyed the roof and third floor of the building, reducing it to two stories. In commemoration of the station’s 100th anniversary, it was decided in 2014 to restore the building to its original appearance and reinforce it against earthquakes. It turned out, however, that the restoration would cost around 50 billion JPY! To cover the high cost, Tokyo Station used air rights, putting the Coase’s theorem into practice.

Floor area ratio (FAR) is the size of a building (or the maximum floor space) that is allowed to be constructed on a given piece of land. The Marunouchi area where Tokyo Station is located is permitted to construct high-rise buildings and designated as a special FAR district, meaning that buildings there can transfer or sell portions of unused FAR to other buildings. Instead of constructing a tall building, the station’s owner (the East Japan Railway Company or JR East) sold its air rights to neighboring buildings and were able to raise the money to restore the historical building and make it earthquake proof.

3 Emissions Trading: Application of the Coase Theorem

A scheme that applies the Coase Theorem while treating the problem of transaction costs is emissions trading. In an emissions trading scheme (hereafter called “ETS”), property rights to the environment are permits to emit pollutants. With the aim of reducing not only emissions but also transaction costs, ETS has affected parties trade the allowances issued by government in the emissions market instead of having them bargain individually. Various ETSs have been adopted in countries and regions including the EU, U.S., Korea and China. An international ETS for greenhouse gas (GHG) emissions was proposed as a climate change measure in the Kyoto Protocol. The protocol was negotiated in 1997 and came into force in 2005 to establish international agreements to reduce GHG emissions cooperatively.

Let us take a closer look at how ETS works. Government first sets the acceptable level of GHG emissions in the economy. The target level is set based on various factors and is therefore not necessarily equal to the socially optimal level that the government aims to achieve by implementing environmental taxes. The government creates a permit, or the right to emit one unit of GHG emissions, issues permits only up to the total emissions limit that was set initially, and distribute the permits to firms. The amount of permits distributed to firms usually depends on their emissions levels in past years (grandfathering). As we will see later, the initial distribution will not influence the burden of ETS on the economy. Firms can then emit GHGs as much as their allowances permit. If they reduce emissions and have allowances to spare, they can opt to gain profit by selling them to other firms. Conversely, if their emissions level exceeds the allowances, they can buy additional allowances from others in the market to offset their emissions.

Governments should take initiative at the initial stages of establishing an allowance market, because firms are unfamiliar with the idea of property rights to produce emissions and thus may hesitate to buy and sell the rights. In addition, it is necessary for the government to monitor not only the approximate number of allowances held by each firm but also its emissions volume. Should firms emit more than their allowances, the government needs to enforce a penalty or fine on them. Otherwise, some firms may not comply with their allowances, which can result in a failure to achieve emissions reduction targets in the entire market.

3.1 ETS and Its Significance

Although it may sound unethical to trade property rights to pollute, ETS is a rational mechanism that aids firms into reducing their emissions in a cost-effective manner. Firms that can reduce emissions relatively cheaply will cut back their emissions. If reducing emissions is relatively costly, they will purchase allowances from the market. Consequently, the target level of emissions will be achieved at the lowest cost.

Let us consider the rationale for introducing ETS by using climate change measures as an example. Suppose that the world is composed of just two countries, A and B. Their CO₂ emissions demand curves are represented as Figs. 3.2 and 3.3. As explained in Chap. 1, the area under the demand curves represents utilities (that is, surplus) obtained from emitting CO₂. Emission reduction leads to smaller surplus. In the absence of regulations, the countries do not need to pay for their emissions and hence the price is 0. As a result, E_A⁰ (E_B⁰) is country A's (B's) CO₂ emissions. Total emissions in this world is E_A⁰ + E_B⁰.

Fig. 3.2

Emissions demand curve for country A

Fig. 3.3

Emissions demand curve for country B

The shape of the emissions demand curve is determined by a number of factors including the price of fossil fuels and the economic structure of the country. For this reason, the emissions demand curves are likely to differ in shape across countries. Accordingly, we depict the figure in such a way that the slope of the demand curve differs between countries A and B. In particular, country A's slope is steeper than that of country B, indicating that the cost of reducing emissions is greater in country A than in country B. As a real-world example, Japan has made various investments in energy conservation through the two oil crises of the 1970s and the nation's energy consumption per unit of GDP (gross domestic product) is already lower than that of other developed countries. This made it more difficult for Japan to reduce its carbon dioxide emissions than other industrialized countries. In other words, the cost of reducing emissions was relatively high in Japan when Kyoto Protocol entered into force in 2005 Japan's situation then is similar to that of country A in our example.

To reduce emissions in the world, suppose that ETS is introduced with the goal of setting the total global emissions as Ē. In this case, allowances are set based on the total emissions targets and allocated to both countries. Suppose that country A is allocated with Ē_A.

Under the ETS, once their allowances are allocated, countries A and B can buy and sell their allowances. For example, if the allowance price is P₁, then it is reasonable for country A to emit E_A¹ worth of allowances. Since this amount exceeds the allowances allocated to country A, it has to purchase allowances from country B. Now, let's assume that country A reduces its emissions to E_A¹. The surplus (or income) of country A decreases by area E₀ACE_A¹. This is the cost of reducing emissions in country A.

How is an allowance price determined? If the price is P₁, then emissions in country B is E_B¹. Country B makes decisions about buying and selling allowances, just like in country A. In this case, the total emissions are E_A¹ + E_B¹. If the emissions are greater than Ē, there will be a shortage of allowances and the allowance price will rise. If the emissions are less than Ē, there will be a surplus of allowances and the allowance price will fall. When these adjustments are made and when the total emissions and the emissions targets are aligned, the demand and supply of emissions will balance with each other. This is how emissions trading works.

By using the demand curves for both countries, we can see the level at which the allowance price is determined in the market in more detail. We reverse the left and right sides of the demand curve for country B, as if it were mirrored, and combine that figure with the figure for country A. Let us fit the vertices of the triangle together as illustrated in Fig. 3.4. The length of the two ends of the figure (i.e., O_AO_B) represents the total GHG emissions before ETS is implemented.

Fig. 3.4

Emissions demand curve before the adoption of ETS

To make the total amount of emissions Ē means that the width of this entire figure is reduced to Ē, as illustrated in Fig. 3.5. In this case, the demand and supply of allowances balance with each other at price P* (i.e., the height of the intersection (G) of the demand curves for the two countries). At this price, the quantity demanded by country A (country B) is E_A^* (E_B^*). The total quantities demanded by the two countries are equal to the width of Fig. 3.5, i.e., Ē. If the price is higher than P*, the price falls because the demand is less than the supply, and vice versa, and an equilibrium price P* is expected to be realized.

Fig. 3.5

Emissions demand curve after the adoption of ETS

If the initial allocation for country A is Ē_A, then the country will purchase allowances from country B for the amount of E_A^* – Ē_A. Since the total emissions target is Ē, the initial allocation for country B is Ē_B = Ē – Ē_A. In this case, if the price is P*, country B is willing to sell only Ē_B – E_B^* of its allowances. Here, the supply and demand for allowances balance each other.

Let us look at the transactions of allowances in terms of the cost to each country to reduce its emissions. The sale of allowances by country B means that it will be able to emit less and therefore must reduce its emissions. Doing so is relatively easy for country B because the abatement cost is less for country B than for country A. Country A, where abatement cost is high, does not need to reduce emissions by the amount of allowances purchased from country B. This is a very rational scheme for the world economy as a whole. As a result of emissions trading, country B, where emissions reduction is relatively cheaper, cuts down its emissions by a larger amount; country A, where emissions reduction is more costly, decreases emissions by a smaller amount.

Now, let's consider the total cost of reducing emissions by using Fig. 3.5. In the case where countries A and B trade allowances, emissions produced by country A are E_A^* and by country B are E_B^*, so the total surplus is area O_AFGHO_B. What happens if they do not trade allowances but match their emissions level to the number of allowances initially held? In that case, countries A and B are allowed to emit ĒA and Ē_B, respectively. This is a case similar to the scheme proposed in the Kyoto Protocol, in which emissions targets for developed countries have been determined but allowance trading between countries is not accepted. In this case, the surplus for country A is area O_AFJK and for country B is area O_BHIK, which means that the total surplus is reduced by area JGI. By comparison, we can see that the countries can minimize the total abatement costs by adopting ETS and trading their allowances.

It should be noted that the allowance allocation to countries (i.e., how much allocation is granted to which country) does not affect the abatement costs in the world economy. This is the same logic as in the Coase Theorem that the way in which property rights are allocated does not affect the outcome of bargaining. Nonetheless, the way in which the initial allocation is made will affect which country benefits and how much, and therefore, the adjustments between the affected parties on the initial allocation is not easy.

In sum, ETS is a market mechanism that incentivizes countries where emissions reductions are relatively cheaper to make greater reductions. As a result, the global burden of reducing emissions will be minimized. The money that was supposed to be used on emissions reductions can be spent on something else for more effective purposes. In this sense, ETS is an efficient market-based instrument.

It is important to note that emissions trading is often used as a domestic system. The first successful example of ETS is SO₂ allowance market in U.S. It was introduced to address the issue of acid rain problem and regulated SO₂ emissions from fossil fuel power plants. As we will discuss in Chap. 9, many countries and regions now implement ETS as a major policy instrument to mitigate CO₂ emissions from industries and power plants.

Box 3.4 Marginal Abatement Cost

Environmental economics frequently employs the concept of marginal abatement costs, which is useful for understanding the mechanisms of emissions trading. Marginal abatement costs are the additional costs required to reduce emissions by one unit. Initially, costs are low due to easy reduction options such as energy efficiency improvement through heat conservation. However, as the emissions reduction progresses, easy options diminish and additional costs increase. One example includes R&D expenditures or equipment investment to implement new industrial processes. Thus, a marginal abatement cost curve can be drawn with emission reductions on the horizontal axis and marginal abatement costs on the vertical axis. The curve then rises to the right.

The case study on emissions trading in this chapter can also be understood by examining the marginal abatement costs for each country. Marginal abatement costs of two countries become equal through the price of emission allowances, resulting in efficient emissions reduction. In the case of an environmental tax, emissions are reduced to a level at which the marginal abatement cost is equal to the environmental tax.

Many studies on climate change countermeasures have used the marginal abatement cost curve.

3.2 Transaction Costs in ETS

While emissions trading is an idea inspired by the Coase Theorem, it does not envision bargaining between polluters and victims. By design, the scheme has given up on the idea of maximizing social surplus by bargaining between the two sides. Under the scheme, the government sets the total allowances, and a certain amount of emissions will be reduced at a minimal cost by having polluters trade their allowances. This avoids the problem of transaction costs, i.e., what hinders bargaining between victims and perpetrators, and facilitates trading between polluters.

In practice, when adopting ETS, governments may have to facilitate the setup of the market to prevent the cost of transactions from becoming too great. It has been observed that after a certain period of time, the cost of trading declines and polluters will be able to trade allowances smoothly. As long as transaction costs are taken into account, ETS can be an effective solution, particularly for environmental problems in which a large number of polluters are involved.

3.3 ETS and Environmental Tax

It is also worth noting the relationship between emissions trading and environmental taxes, as both are price-based systems that efficiently reduce emissions of pollutants or greenhouse gases. Both policy instruments are expected to have similar effects in terms of economic efficiency. It is important to note that while the two policy instruments may have similar economic effects, they differ in their ability to achieve environmental objectives. If both countries were to implement an environmental tax at P*, they would achieve the same level of emission reductions under ETS in this example.

However, in practice, the two policy instruments have different characteristics in terms of achieving environmental goals. Emissions trading ensures that emission reduction targets are met, while a tax makes it difficult to predict the amount of emission reductions in advance. Additionally, environmental taxes and emissions trading have distinct effects and implications in cases of uncertainty regarding the emission demand curve and marginal abatement costs. Chapter 4 addresses this topic.